India's Weekend Maneuverings and Debt Problem

A smaller than expected stimulus package may be signs of things to come…

Prime Minister Singh’s government announced a series of economic measures including a 100bp rate cut and reduced fuel prices with much fanfare this weekend, but even the most dedicated India bull found the government stimulus package unveiled yesterday to be a let-down.

At just $4 billion in total with about only $2 billion (less than 0.10% of 2007 GDP) earmarked for new spending in the remaining four months of the fiscal year, the plan is less than a third of some of the amounts rumored in the press earlier in the week.

The small size of the relief package may, in part, underscore the increasingly significant role that external debt has played in the Indian economy since the start of the recent decade of hyper growth, which kicked off at about the same time that IMF repayments ended. As illustrated by the chart below, as total foreign debt levels increased, so too did the percentage of short term debt –over 20% by Q2 of this year, leaving the private sector and, by extension, the government, facing looming refinancing in the midst of a global credit draught.

Plans for the Stimulus package include a provision for a $1 billion domestic offering in March, which will be a significant increase over prior issues. Already the most recent treasury auction came to market for nearly double the size anticipated –in conjunction with an increase of government forecasts for 2009 issuances that exceeded the original target by more than 30%.

In an interview in HT’s financial journal MIN this week, Harihar Krishnamurthy, director of the treasury at the Development Credit Bank, sounded less than confident when he pronounced that the new debt issues “won’t affect the market because by the time of the January borrowing, the advance tax collected in December will come back in the system and there won’t be any liquidity problem”. In other words, by the time the check clears the money will be in the bank.

The yield curve has remained flat since coming off the highs of late July with the 10 year at 6.77 and the 2 year at 6.53 –a nominally low level by historical standards. As the foreign appetite for debt issued by Indian financials drops off on currency volatility and solvency concerns, that trend could reverse rapidly as banks have less money to lend the government. Already last month Tata Financial had to seek regulatory approval to attach warrants to a rights-offering zero coupon issuance in order to find willing offshore buyers.

In announcing the rate cut, Reserve Bank Governor Subbarao admitted that growth would be “less than expected” but there has yet to an official acknowledgement that high double digit growth is impossible for the New Year.

Being short India for the better part of 2008, we have repeatedly underscored our doubt that domestic demand can replace a drop-off in foreign trade. Now we add to that our doubt that domestic credit alone can replace foreign lending.

Andrew BarberDirector

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12/07/08 01:55 PM EST

Eye On Re-Regulation: "Where There's Smoke"

Where There’s Smoke… Notes for the Week Ending Friday, December 5, 2008

Grin and Bair It

Sheila Bair, Bush-appointed Head of the FDIC and, according to Forbes Magazine (8/27/08) the “Second Most Powerful Woman In The World” (after Germany’s Angela Merkel) is being set up to take a fall. Ms. Bair is on record as being among the first (October 2007) government officials to warn about looming calamity in the mortgages market and its knock-on effect in the broader financial markets. More recently, her refusal to budge off her criticism of the Bush Administration’s management of the crisis, and Secretary Paulson’s monarchical handling of his private $700 billion slush fund, won her broad praise in Congress, and among the public.Now she is being trash-talked by Tim Geithner, the man she called “a great pick” as President-Elect Obama’s nominee for Secretary of the Treasury. (“Geithner May Seek to Push Bair Out After Clashes During Crisis”, Bloomberg.com, Thursday, December 4). The Bloomberg story quotes Congressional sources: “Geithner, president of the Federal Reserve Bank of New York, has argued Bair isn't a team player and is too focused on protecting her agency rather than the financial system as a whole…” Says former Treasury official Wayne Abernathy, “The idea of having an independent actor on the stage with you who might not be singing the same tune can make you nervous. They recognize that she's a very independent person.” Hmmm…Those of us with Ivy League MBAs remember the famous business school case of the Bay Of Pigs Invasion – the decision-making process surrounding that failed military action gave rise to one of the most famous B-School buzzwords: Groupthink. In a View of the Day opinion piece in the Financial Times of Thursday, December 04, 2008, David Bowers of Absolute Strategy Research says government almost always does too little, too late; but in the current crisis the risk may be that Government is doing Too Much, Too Soon.We remember the mad rush after 9/11 to pass the USA PATRIOT Act. In very short order, fundamental requirements of the Act were watered down in deference to Wall Street’s argument that “no one can do business under such restrictive rules.” Quicker than Harry Potter can say “Dissapear-O!” the requirements that financial institutions know the true source of funds for transactions were waived. Instead, firms were permitted to rely on other financial firms’ compliance procedures. Ultimately, there were whole sequences of funds transfers, all relying on one bank to have done its diligence. We are reminded of the flaws in this methodology by this week’s update (Associated Press, December 3, “Bank of New York Gains on Upgrade Linked to Suit”) reporting the latest development in the 2000 case where a Bank of New York executive was accused of laundering $7.5 billion of Russian money.The purpose of oversight procedures is to prevent outlier disasters. It is instructive to scan the FINRA website for monthly regulatory disciplinary actions. There is typically a roll-call of the highest-profile, and generally best managed firms in the industry, all getting dinged for amounts ranging from five thousand dollars, up to perhaps $25,000, for ministerial glitches leading to infractions of marketplace rules. In a typical month, these will include late trade reporting, failure to timely update quotes, reporting trades out of sequence without the proper modifier, and inadvertently trading through prices when there was still liquidity in the marketplace. In this way, both market regulators, and internal compliance procedures keep the industry honest.Large compliance catches by firms are generally the result of long hours of routine internal reviews. Mid-level compliance staffers who look at execution reports all day long and suddenly notice a pattern of trades being reported out of sequence have uncovered coordinated programs of market manipulation. Routine daily reviews have identified parking of trades, manipulations of net capital computations, traders diverting profits into proprietary accounts, and brokers perpetrating massive fraud against customers. You name it, it’s been tried on Wall Street. And you name it – we have caught it.Government, like finance, is an art, not a science. In defense of Secretary Paulson, Chairman Bernanke – and even his predecessor, Chairman Greenspan, now the focus of a universal campaign of revisionism – it is only in the benefit of hindsight that we can tell which policies worked, and when they stopped working, and why.Chairwoman Bair proposed using $24 billion to prop up individual families. Her analysis predicted that this investment could realistically save 1.5 million mortgages. Who knows? Maybe it would work. Set alongside the current program, Ms. Bair’s proposal looks like keeping 1.5 million families in their homes where they can continue to be taxpayers and consumers. Chairman Paulson’s approach, on the other hand, is the ultimate in Trickle-Down marketology. It is the financial markets equivalent of a screen pass in football: the quarterback waves 700 Large in the air, then lobs a bloop over the heads of the defenders and into the waiting arms of – not to single anyone out – Jamie “We-don’t-need-the-money-but-we’ll-take-it” Dimon.Successful organizations plan for worst-case scenarios. Best-case scenarios take care of themselves; the fat part in the middle of the bell curve creates neither tremendous wealth, nor unacceptable risk to the institution or the marketplace. Prudence – what the world of regulation calls Best Practice – dictates that there be someone on the team to oppose the Group’s Thinking.We recognize there have been severe deficiencies in the regulatory system. But pouring cash into the hands of the already-wealthy and requiring nothing in return is not a cure, particularly now that the competence of the recipients of this windfall has been called into question. Giving an addict free heroin keeps him from committing crimes, but it neither cures the addict, nor benefits society.

According to the Financial Times (FT.com Wednesday, December 3, “Treasury Tackled over TARP Concerns”), the Government Accountability Office (GAO) has expressed grave concerns that the $700 billion in TARP monies are being doled out without controls in place to ensure compliance from the institutions receiving the monies, and without any metric to determine what effect the TARP money is having in the marketplace. It is the financial equivalent of a Black Hole. It does not surprise us that Neel Kashkari, head of the TARP program, sent GAO a note saying that he “disagreed” but “welcomed discussion on ‘general metrics’ for evaluating the overall success” of the program. Oh, we forgot – Mr. Kashkari comes from Goldman Sachs. We guess it’s all right, then.

Sheila Bair is the Fly in Secretary Paulson’s Ointment. Good so. Let someone with brains, command of facts and figures, and a really big regulatory hammer to wave stand in the room and be the sole dissenter. Why should Hank Paulson, Ben Bernanke, George Bush – and now Timothy Geithner – be the only ones who have the unassailable right to be wrong? And even when they get it right, lockstep is always wrong-footed.

Mr. Geithner was irked by Ms. Bair’s stubbornness during the rush to complete the $300 billion Citi guarantee. It appears Mr. Geithner was leading a desperate charge to Get It Done Now, while Ms. Bair demurred based on key fundamentals: my Agency’s job is to protect deposit holders; my Agency may be prohibited by law from financing this transaction; no one has explored the ramifications. And just plain old – I don’t agree with you, and I am not going to cede responsibility just because all your guys are ganging up on me.

The legal argument should not be taken lightly, by the way. With major law firms downsizing, merging, or just plain shutting their doors, there are now record numbers of lawyers out of work in this country – and many of them are smart. When the dust settles, do we foresee the possibility of lawsuits being launched against the Government for urinating away our money? Would you take a one trillion dollar lawsuit on contingency? Say, against Barney Frank for “rolling the dice” (his words, not ours) on the residential mortgage market? Against Secretary Paulson for the nepotistic appointment of a 34-year old Wunderkind to run an opaque $700 billion give-away program whose beneficiaries are the Secretary’s golfing buddies? We just bet there are lawyers out there in America already working up the legal theories. Quoth King Henry II: “Will no one rid me of this meddlesome priest?” And Thomas Becket was slain. We fear the Tim Geithner is even now whetting his blade to do the bidding of his own King Henry.

Where does this leave us – and where does it lead to?

Thursday’s Wall Street Journal (“SEC Tightens Rules for Ratings Firms”. Thursday, December 04, 2008, page C3) quotes New York Senator Charles Schumer: “None of the rules adopted today are a substitute for the larger regulatory reform that is coming next year.” Here is what we see as a likely scenario. And remember: You heard it here.

President-Elect Obama is masterful. He is highly intelligent and fearsomely well organized. We have high hopes that he will run as well-executed a Presidency as he did a campaign. And, let’s be honest, he is a ruthless and extremely effective politician.

President-Elect Obama is both wise and absolutely correct in not offering specific policy guidance on the current crisis. There is, as he has observed, one President. In fairness, the Obama Administration is inheriting one hell of a mess, and it is no wonder that he doesn’t want to step into this alligator pit until he absolutely has to.

We suspect that, true to the successful pattern of President Clinton – nay, true to his own successful maneuvering during the campaign – President Obama will run with the Conservative trickle-down he is inheriting, because that is what the power base of the country wants, and it is anyway too firmly entrenched to flip over in one administration. Congress is getting ready to toss not just a bone, but an entire cow to the auto industry. Meanwhile, the Democrats will no more go after Vikram Pandit than they will after Mom and apple pie. They may require Mr. Pandit to subsist on one dollar for fiscal ’09, but that is not the equivalent to the 1.5 million mortgages that will not be saved by refusal to implement Chairwoman Bair’s plan.

As we go to press, Ms. Bair is quoted (“”FDIC’s Bair Sets to Shatter CRA ‘Myth’”, Housingwire.com, Friday, December 5th) as saying, “only one in four higher-priced first mortgage loans were made by CRA-covered banks during the hey-day years of subprime mortgage lending. The rest were made by private independent mortgage companies and large bank affiliates not covered by CRA rules.”“Let me ask you,” she continues, “Where in the CRA does it say to make loans to people who can’t afford to repay? Nowhere.” Plain English: the irresponsible lending practices that led to today’s market meltdown today arose from 75% private-sector greed, and 25% irresponsible government regulation. To us, “only one in four” sounds like a defendant arguing that robbing “only” three banks is “hardly a spree”. Add to this the high praise Ms. Bair has received from Chris Dodd and Barney “Roll-The-Dice” Frank, and we admit to being somewhat uncomfortable. Still, Chairwoman Bair is the only member of Team Obama who can be characterized as the Loyal Opposition. For this reason alone, the country deserves to have her on the job.

We suspect that the Obama Administration will combine the knee-jerk excesses of Team Bush, with the Spread the Wealth mandate on which President-Elect Obama won election. The machine will be designed to take in hundred-dollar bills and spit out quarters, and the regulators of the banks and financial marketplace will be charged with ensuring that the change-making process runs smoothly and that every coin and bill is accounted for.

In terms of marketplace regulation, we fear a retrenchment of rules-based Old Timers, certainly in the initial stages. Senior regulators have spoken thoughtfully about Principles-Based Regulation, but much as it makes sense, it is a generational change.

Note the following: Tens of thousands of people are out of work on Wall Street. Many of them truly deserve to be, because there has never been an enterprise in the history of humankind that so over-rewarded mediocrity – nay, sheer incompetence – as the investment banking and brokerage industries.

Venality and dishonesty, by their very nature, attack the lowest of the low-hanging fruit, and Wall Street has been the home of Those Who Soon Part the Fool From His Money for the better part of three decades – intermittent blips and bear markets notwithstanding.

What these former Wall Street professionals are now doing is sending resumes to the SEC, on the premise that a Government Job is a Safe Job. And therein lies the rub: the entrenched regulatory infrastructure is the Rules-Based infrastructure. Not just at the SEC, but across the regulatory spectrum. We are aware of pockets of excellence in the regulatory system, and of senior-level regulators who are staffing their teams with exceptional former Wall Street professionals, with a specific goal of bringing in people who truly understand the industry from the ground up . Still, we predict that, under an Obama Administration, the bifurcation of the marketplace will continue apace: money will be thrown in large quantities at the large financial institutions – now add in large industries – and regulation to protect the small investor will run riot, at least in its initial stages. The palliative will be tight controls on executive compensation (“Will no one rid me of these meddlesome investment bankers?”), but the fundamental deficiencies of the rules-based regulatory system will persist until a new generation of regulators, bred from seasoned Wall Street and commercial banking professionals, is able to move into the management, and the rank and file of the regulatory agencies (“Will no one rid me of these meddlesome regulators?”). We hope there will be enough elasticity in the system to give this process time to take hold, but we believe there is not. In preparation for the next phase of the evolution of the American marketplace, we have decided to learn Mandarin.

We wish the new Obama team success on the economic front. They will need laser-like focus, determination, smarts, and a blessing or two to pull this all together. In the interest of staving off Groupthink, they need a Fly In The Ointment. We respectfully urge President-Elect Obama to appoint Ms. Brooksley Born to head up a major regulatory effort – it doesn’t matter which one, just get her into the government with some real authority. And keep Sheila on the team. Trust us on this one, Mr. President-Elect. Some are accusing her of hogging the ball, but she may be the only player who can prevent you getting sacked in your own end zone. What quarterback wants to go down in the record books as losing the Super Bowl by a safety?

Will No One Rid Me Of This Meddlesome Economist?

Finally, a government policy with some teeth. Do you remember the old joke – “I read so much about the dangers of smoking, I gave up reading”? The Wall Street Journal (Monday, December 1, Page A1) reports that Latvia’s state counterespionage and anti-terror agency recently detained for questioning one Dmitrijs Smirnovs. Mr. Smirnovs, a 32-year old university lecturer in Economics, was quoted in a newspaper roundtable as advising people not to keep their money in Latvian banks, nor in the lat – the local currency. The Journal article quotes Teodors Tverijons, head of the Association of Latvian Commercial Banks, as saying “We are a small country, and panic would have very grave consequences.” This is, said Mr. Tverijons, a “matter of state economic security.”

Not knowing how far the tentacles of the Latvian Secret Police may reach, we do not care to offer an opinion on the internal affairs of a sovereign nation. We merely note that some governments are very effective in dealing with dissent. Mr. Smirnovs was released after two days of questioning, and he has not been charged. Mr. Smirnovs, while not guilty of any crime, is clearly Not A Team Player.

Mr. Tverijons has a point. Imagine the consequences of a financial panic in such a small country as Latvia. Or in such a large one as the United States. Is the next step House Arrest for Sheila Bair?

We are watching.Moshe SilverDirector Of Compliance

Keith R. McCulloughCEO / Chief Investment Officer

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12/07/08 01:40 PM EST

’09 Theme: Cut Capex? Or Go In For The Kill…

The majority of retail companies have announced ’09 capex cuts – at an avg of 25%. Most need that, if not more. But it’s time for those with the right (and liquidity) to exist to go for the jugular.

Are any of us surprised that 80% of retail-related companies that recently announced earnings noted a meaningful cur to capex in CY09? I’m really mixed on this. On one hand, cash is king, and in ‘The New Reality’ that we’re facing today there are a lot of companies that simply have not earned the right to grow. In fact, they need to shrink – if not go away. They could, and should pull back on any plans to grow and try to protect their existence as much as possible. But there are other companies that are in the driver’s seat. They have strong brands, strong liquidity, adequate pre-existing investment base, and the consumer genuinely wants them to succeed. I’m talking Under Armour, Ralph Lauren, Coach, Lululemon, Abercrombie, Nike and a few others. These are companies that should be stepping up investment spending, and putting the competitors out of business.

Keep in mind that there are different types of capex. This is a time to think strategically and blaze new trails in The New Reality. Why shouldn’t these power brands by e-tailers to build an internet fulfillment operation to double their consumer-direct platform? Why not flex muscle to secure assets – both on and off balance sheet – at a time when the weak simply need to stand by and watch? I’ve got a dozen ideas swirling around in my head. The strat planning teams at the big firms better be a couple steps ahead. If not, they are missing on the opportunity of a lifetime and are probably justifying the troughy multiples they currently garner.

COMMENTS ON CAPEX, BUT NO QUANTIFICATION.PSS: “We expect our 2009 capital spending will be notably lower than the approximately $130 million that we anticipate spending this year.”

GES: “Regarding store expansion we currently have 17 deals that are committed in North America and three in Europe. We plan to carefully evaluate any future store opportunities for next year by currently estimate that our store growth will be significantly slower than this year. Consistent with this we estimate that capital expenditures will be below this year's levels as well.”

ARO: “As you know we typically provide CapEx projections on our fourth quarter call. And that's the call where we'll break out the new store openings by concept as well as renovation, so right now we just wanted to communicate to the Street and investors that we are contemplating a reduction in our overall planned capital expenditures at this point.”

RL: “We have a re-evaluated projects planned for fiscal 2010 and expect to communicate our capital earnings outlook for fiscal 2010 on a future call.”

JNY: Cutting back cap ex but did not give a number.

No Comment List: TBL, ANF, FINL, FL

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Quote Of The Week: The Chinese Are Coming!

This quote was a beauty. The only thing better than “Heli-Ben” and Bushy dropping moneys from the heavens is the idea that hundreds of Chinese men and woman are going to descend on Floridian property gluts and rescue American homeowners from their levered up losses.

Geoff Dyer’s article was inspired by “SouFun”, which is the largest dot com site in China for real estate. Apparently some 300 Chinese “expressed interest” in soaking in some of fun in the foreclosure sun of California. Oh how times have changed folks. The Chinese are liquid long cash, reminding the USA what being a capitalist means. Buying low, not high.

Since the first week of November, the Chinese Capitalists have plenty of their own “Re-flating” moneys to count. Inclusive of a +6.7% three-day rally to close out this week, the Shanghai Stock Exchange Index has put on a +18% move. This stands in sharp contrast to the depression in some of the homes of levered long American wanna be capitalists who saw the SP500 close down another -2.3% this week, taking the US market’s performance over the same period (from the 1st week of November) to down -13%.

CNBC’s “Fast Money” literally used to get away with espousing strategies of “buy high and sell high-ah!”, while Larry Kudlow used to proclaim his mystery of market faith by having his group thinkers say “free market capitalism is the best path to prosperity.” Watch what these American entertainers do, not what they say. Begging for bailout moneys and government sponsored help is no definition of capitalism. Neither is the notion that buying low and selling high is passé.

Capitalists are called capitalists, because they own themselves and their process… and they capitalize on opportunities to buy low. They don’t need government supports. They don’t need to ask for permission. They are liquid long cash when the lemmings are levered. They may be coming to a neighborhood near you, knocking on your door… looking to mark your home to market!

Just as readily as American Capitalists were 100 years ago, the Chinese are coming.KM

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12/07/08 01:14 PM EST

Eye on Employee Productivity

Employee productivity always matters, but I’m increasingly interested in the investment base to sustain such levels. The numbers suggest that some companies are more at risk than others.

With pressure on profitability mounting and the outlook for 2009 increasingly uncertain, cost control matters more than ever to buoy profitability. What many people fail to remember is that 70% of discretionary (non-COGS) costs in this business relate to headcount – both directly (# people) and indirectly (T&E, IT, etc…).

So how best to peek inside a company to gauge whether cuts are coming from fat or muscle? I think a fair way is to plot each company’s productivity versus total SG&A ratio. This is by no means a way to make blanket statements about which companies are behaving better than others as it relates to capital deployment – especially given that there are differences in business models (wholesalers, retailers, and vertically owned manufacturers). But it definitely helps us put the data in perspective, and ask the appropriate questions about where one company stands relative to another.

There are 2 major buckets of companies.1) High productivity, high SG&A ratio. These are companies I am least worried about. They have mostly healthy productivity levels, and have either a) given employees the proper tools to maintain such productivity (R&D, marketing, technology, etc…) – such as Nike, UnderArmour, Ralph Lauren and Coach, or b) are just flat-out fat and/or poorly run with room to cut (Timberland, Quiksilver, Liz Claiborne). That’s not great for the here and now, but certainly leaves a nice call option.

2) Low productivity, low SG&A. First off, I fully acknowledge that this group includes several retailers and the two vertically operated manufacturers, who have more of their respective investment bases captured on (or near) the balance sheet in the form of equipment or leases. But it’s impossible to look past some massive gaps in SG&A spend on like-for-like businesses. FL, DSW, and GIL bad; FINL PSS and HBI good. You get the idea.

See chart below, and/or contact my office for additional color.

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12/07/08 12:42 PM EST

Chart Of The Week: Global Rates

From the heavens they came, dropping free moneys on all of those who are still allowed to trade the futures. Our holiday greetings and many thanks go out to “Heli-Ben” and his global air force of Japanese B-52 cash money bombers. Ben, you have inspired us all to take this baby right back up to 10,000 feet again. Never mind the naysayers calling ole Greenspan the “Grinch”… let’s deck the halls with 0.01% three-month US Treasury rates and “Re-flate” some of them Bushy bubbles!

All the while, lumps of cost of capital coal have seemingly found their way to Russia and Pakistan. Both were forced to actually raise rates in recent weeks. This has been horrible for Russian equity investors, and a non-event for the folks in Karachi, where they just keep the stock market closed, rather than get “stoned” by their populous.KM

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